slide 1 © carliss y. baldwin 2008 where do transactions come from? modularity, transactions and the...
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Slide 1 © Carliss Y. Baldwin 2008
Where Do Transactions Come From? Modularity, Transactions and the Boundaries of Firms
Carliss Y. Baldwin
Organizational Economics SeminarMITFebruary 14, 2008
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Slide 2 © Carliss Y. Baldwin 2008
Motivation: A Movie of Industry Evolution
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Slide 3 © Carliss Y. Baldwin 2008
Computers, 1979
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Slide 4 © Carliss Y. Baldwin 2008
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Slide 29 © Carliss Y. Baldwin 2008
Lots of New Firms
With attendant transactions and boundaries Transaction-cost economics and property
rights theory cannot explain why industry structure changes
As industry evolves where will new firm boundaries appear?
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Slide 30 © Carliss Y. Baldwin 2008
Contributions of the paper Task network model of production applied to
transactions Synthesis of transaction cost theory, property rights
theory and multi-tasking models of incentives and firm boundaries with modularity theory
Theory of technological change that explains changing transaction locations and changing industry structure
Theory of Transaction-free Zones—their existence and two basic forms
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Slide 31 © Carliss Y. Baldwin 2008
Outline
Literature Definitions Transaction Location Transaction Design Modularization Transaction-free Zones
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Slide 32 © Carliss Y. Baldwin 2008
Literature
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Slide 33 © Carliss Y. Baldwin 2008
Transaction Cost Economics and Property Rights Theory
Based on a sequence of stages model of production (Coase, 1937; Williamson, 1991; Grossman & Hart, 1986; Hart & Moore, 1990; Baker-Gibbons-Murphy, 2002)
– Upstream supplies Downstream
– Two stages, one interface
Property rights theory takes incompleteness of the contractual interface as axiomatic – Given incompleteness, the task is to locate residual control rights
(“ownership”) (Grossman & Hart, 1986; Hart & Moore, 1990; Hart, 1995)
Design of the interface is outside the theory– What exactly passes between Upstream and Downstream?
– Not a question in these literatures
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Slide 34 © Carliss Y. Baldwin 2008
Knowledge-based Theories of the Firm
Reaction to TCE and Property Rights theory Firms are a way to package/divide relevant
knowledge Knowledge gives rise to Capabilities/
Competencies /Routines But knowledge boundaries are not
transactional boundaries …“Firms know more than they make.”
(Brusoni, Prencipe, Pavitt, 2001)
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Slide 35 © Carliss Y. Baldwin 2008
Modularity Theory More micro than the other theories
– Looks at the internal structure of products and processes
Mirroring hypothesis (Henderson and Clark, 1990)
– “Organizations are boundedly rational, and, hence… [their] structure comes to mirror the internal structure of the product they are designing.”
Product module boundaries = Organizational boundaries – [= Firm boundaries] is a common assertion
– but many counterexamples» One firm, many modules
» Several firms, one module
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Slide 36 © Carliss Y. Baldwin 2008
What does the internal (modular) structure of products and processes imply for transactions?
Our topic today…
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Slide 37 © Carliss Y. Baldwin 2008
Definitions
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Slide 38 © Carliss Y. Baldwin 2008
Network graph of how something gets made/produced – Engineering perspective
Imagine a graph of ALL transfers of material, energy, information between Upstream and Downstream– “Activity system” (Porter)
This is a directed graph– Unlike social network graphs
Task network
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Slide 39 © Carliss Y. Baldwin 2008
Design of an Aircraft EngineSosa, Eppinger, Rowles, Management Science, 2004
Within a single firm—Pratt & Whitney
8 subsystems, 54 components, 54 teams
TRANSFERS from column to row
TRANSFERS NOT TRANSACTIONS
Potential Flowpath of TRANSFERS
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Slide 40 © Carliss Y. Baldwin 2008
Mutually agreeable set of transfers with compensation
To make a transaction, you must– Define– Count (Measure)– Compensate
Cost of this work = Mundane Transaction Costs Contrasting definitions
– Williamson: “transactions are the unit of analysis”– Greif: transaction is any social interaction (even with
God)
Transaction
Absense <=> Incomplete Contract
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Slide 41 © Carliss Y. Baldwin 2008
Transaction Location
Mundane transaction costs are low at module boundaries and high in module interiors.
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Slide 42 © Carliss Y. Baldwin 2008
What is a module?
A module is “a group of elements (tasks) that are highly interdependent on one another, but only weakly dependent on elements outside the module.” (Baldwin and Clark, 2000)
Modules are near-decomposable (Simon, 1969)
Ergo, module boundaries are thin crossing points in the task network
Ergo, modules hide information (Parnas, 1974)
– Information hiding ≠ Different knowledge
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Slide 43 © Carliss Y. Baldwin 2008
Example—Smithy and KitchenSmithy Kitchen
CGS1 S2 S3 S4 S5 K1 K2 K3 K4 K5
CG .
S1 x . x x x x
Smithy S2 x x . x x x
S3 x x x . x x
S4 x x x x . x
S5 x x x x x .
K1 x Pot Hookx . x x x x
Kitchen K2 x Transfer x . x x x
K3 x x x . x x
K4 x x x x . xK5 x x x x x .
Why locate the transaction at the module boundary?
Minimum knowledge overlap (KBT)
With LOW mundane transaction costs you can achieve a MORE complete contract => LESS opportunism
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Slide 44 © Carliss Y. Baldwin 2008
When modules are well-defined
Humans locate transactions at module boundaries “without thinking.”
We exchange finished, usable goods, not partly finished, unusable ones.– Conserves knowledge. – Reduces MTC, hence incompleteness, hence
opportunism.
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Slide 45 © Carliss Y. Baldwin 2008
Transaction Design
Can you have a transaction at a thick crossing point…
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Slide 46 © Carliss Y. Baldwin 2008
Can you OUTSOURCE Design and Production of the FAN system?
The dependencies don’t go away by themselves!
Out-of-block dependencies make this a THICK crossing point
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Slide 47 © Carliss Y. Baldwin 2008
Transaction Design Options—1
Minimal Transaction Design– Pay for Fans only– Spot market transaction
Mundane Transaction Costs —Low Opportunistic Transaction Costs—High
– Williamsonian holdup (both ways)– Defensive investments (Grossman-Hart-Moore)
– Uncompensated multi-tasking (Holmstrom & Milgrom, 1994)
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Slide 48 © Carliss Y. Baldwin 2008
Transaction Design Options—2
Maximal Formal Contract– Pay for everything– At at thick crossing point, “everything” is a lot!
Burden of Mundane Transaction Costs– Accountants outnumber the workers!
Opportunistic Transaction Costs– Unnecessary transfers (“scorecarding”)
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Slide 49 © Carliss Y. Baldwin 2008
Incomplete contract optimal (Hart 1995)
0
Transaction Complexity
Benefits and Costs ($)
Total Transaction Cost
Benefits of Transaction
Opportunistic Transaction Cost
Mundane Transaction Cost
Optimal TransactionDesign
Minimum Complexity Maximum Complexity (depends on thickness of
crossing point)
FormalContract
Costs of:
Property rights (residual control rights) limit ex post damage of renegotiation
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Slide 50 © Carliss Y. Baldwin 2008
Transaction Design Options—3
Relational Contract (Baker, Gibbons, Murphy, 2002)
– Manage by exception– Create “shadow of the future”
Burden of Mundane Transaction Costs– Less needs to be defined and counted
Opportunistic Transaction Costs– Less opportunism as long as outcomes stay
within reneging bounds
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Slide 51 © Carliss Y. Baldwin 2008
At a Thick Crossing PointRelational Contracts are better…
0
Transaction Complexity
Benefits and Costs ($)
Total Transaction Cost
Benefits of Transaction
Opportunistic Transaction Cost
Mundane Transaction Cost
Optimal TransactionDesign
Minimum Complexity Maximum Complexity (depends on thickness of
crossing point)
Mundane Transaction Cost
Opportunistic Transaction Cost
Total Transaction Cost
FormalContract
RelationalContract
Costs of:
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Slide 52 © Carliss Y. Baldwin 2008
But you can also design the task network to suit the transaction.
Redesigning the task network is called…
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Slide 53 © Carliss Y. Baldwin 2008
Modularization
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Slide 54 © Carliss Y. Baldwin 2008
Software System with Licensed-in Code (La Mantia et. al. 2008)
Before Modulariziation
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Slide 55 © Carliss Y. Baldwin 2008
Software System with Licensed-in Code (LaMantia et. al. 2008)
Before Modulariziation After Modulariziation
Licensed Code
No Depend- encies
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Slide 56 © Carliss Y. Baldwin 2008
Notice how well this story fits with Grossman-Hart-Moore’s theory
Misaligned property rights (to code) Led to costly ex ante investment (change code
structure) To improve ex-post bargaining position (re-
licensing) What’s new is a prediction about the nature of the
defensive investment + Tactical advice– Isolate purchased code behind a modular interface
Story also fits Baker-Gibbons-Murphy: A relational contract would have mitigated the problem
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Slide 57 © Carliss Y. Baldwin 2008
Modularizations in Support of Transactions
Standardized Interfaces– Langlois and Robertson, 1992, stereos and PCs, – Sturgeon, 2002, modular production systems – Jacobides, 2005, mortgage banking
Single Point of Contact– Mayer and Argyres, 2004, software– Staudenmayer et. al., 2005, various
Crossing points were made thinner, but can still be very thick!
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Slide 58 © Carliss Y. Baldwin 2008
But there are other reasons to modularize…
Manage complexity Allow parallel work Create options to innovate
See Baldwin and Clark, Design Rules, for examples
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Slide 59 © Carliss Y. Baldwin 2008
Whatever their stated purpose, task modularizations create new module boundaries, with low transaction costs…
IBM System/360 created the disk drive industry via a modular interface
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Slide 60 © Carliss Y. Baldwin 2008
Integrations remove module boundaries, increase transaction costs
Can be used to squeeze out complementors– Vertical foreclosure
– Fixson and Park, 2007, bike drive trains
Or not— With relational contracts can still have an
economical transaction at a thick crossing point– Japanese auto industry, especially Toyota (Sako, 2004)
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Slide 61 © Carliss Y. Baldwin 2008
Transaction-free zones
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Slide 62 © Carliss Y. Baldwin 2008
When tasks are too interdependent to split apart
Humans automatically create “transaction-free zones”
“Stuff happens” without being defined, counted or paid for– Smithy, kitchen, seminars like this one…
From an evolutionary perspective, TFZs are older than transactions– Strong, instinctive social norms apply
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How do you get valuable things into a transaction-free zone?
Birth, adoption, conquest, inheritance, gift Transactions Non-transactional methods are fading in
importance– “Civilization”
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Slide 64 © Carliss Y. Baldwin 2008
Corporations— “Encapsulated” TFZs
Create a “ring of transactions” around an enterprise– Products sold via transactions– Materials, labor, capital, management brought in via
transactions Inside, owners/managers have latitude to design as
they wish—– Even create internal transactions!
Survival of a corporation is predicated on financial sufficiency– Sum of transaction payments must be positive – Otherwise TFZ is bankrupt—must reorganize
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Slide 65 © Carliss Y. Baldwin 2008
Online/Open Source Communities—“Unencapsulated” TFZs
Information flows freely in and out—no transactions at the boundary
Communities make non-rival goods– No threat of holdup
– Don’t want to exclude anyone who might freely contribute resources
Mundane transaction costs become an unnecessary—a burden/drag on productivity
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Slide 66 © Carliss Y. Baldwin 2008
Summary—Empirical Predictions
1. Transactions are more likely to be found at module boundaries than in module interiors.
2. The design of transactions differs systematically with the thickness of the crossing point. Spot transactions are more likely at thin crossing points and formal and relational contracts at thicker ones.
3. The advantages of formal and relational contracts over spot transactions and of relational contracts over pure formal contracts increase with the thickness of the crossing point.
Modular Boundaries and Thickness are observable!
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Slide 67 © Carliss Y. Baldwin 2008
Empirical Predictions (cont)
4. Transactors can sometimes modularize a thick crossing point to reduce transaction costs. Transactional modularization is most likely to occur when the transactors cannot achieve a satisfactory relational contract.
5. In the aftermath of a modularization, entry and competition will arise at the new module boundaries.
6. Transaction-free zones are needed to facilitate complex, interdependent transfers in the task network. Zones that produce rival goods or require large amounts of indivisible capital will be transactionally encapsulated, taking the legal form of modern corporations. Those that produce non-rival goods using low levels of capital can succeed as open zones without well-defined transactional boundaries.
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Slide 68 © Carliss Y. Baldwin 2008
Contributions of the paper Task network model of production applied to
transactions Synthesis of transaction cost theory, property rights
theory and multi-tasking models of incentives and firm boundaries with modularity theory
Theory of technological change that explains changing transaction locations and changing industry structure
Theory of Transaction-free Zones—their existence and two basic forms
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Slide 69 © Carliss Y. Baldwin 2008
Limitations of the paper
No universal theory of “the” firm Anything goes inside a financially sufficient
Transaction-free Zone– Freedom of design– Can have transactions within a zone
» transfer pricing
– Don’t need transactions at the boundaries of a zone
» online/open source communities
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Slide 70 © Carliss Y. Baldwin 2008
“Firms are like lumps of butter coagulating in a pail of buttermilk.”
Robertson, quoted by Coase, 1937
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Slide 71 © Carliss Y. Baldwin 2008
Thank you!